New Sources of Bank Funds: Certificates of Deposit and Debt Securities

Abstract

In a free-enterprise economy such as that of the United States it is the vital function of the money and capital markets to allocate the limited supply of savings among the virtually limitless investment opportunities available. Surplus funds are accumulated by some individuals, business firms, public agencies, and other savers; these funds are borrowed by other individuals, business firms, public agencies, and other borrowers for investment in new homes, production facilities, schools and highways, and the like. Financial institutions such as commercial banks, savings and loan associations, and insurance companies serve as intermediaries between savers and borrowers. These financial intermediaries compete for the funds accumulated by savers through both the price and the quality of service they offer. Borrowers compete for funds by means of the interest rate they pay and the degree of security of the loan or investment they provide. It is the economic function of the financial intermediaries to scrutinize each loan or investment opportunity to insure that the funds channeled through them are directed into the investment applications which afford the least risk of loss with the highest prospect of a profitable return on the savers' money invested. In this way the money and capital markets provide a mechanism by which the scarce supply of savings may be channeled into the most productive uses and hence by which economic growth and progress may be maximized. Financial intermediaries perform other functions which facilitate the flow of savings into investment. By accepting the relatively small accumulations of money from individual savers and making the funds available to meet the relatively large investment needs of borrowers, they provide a diversification of risk which would not be possible if the investment by savers were direct. Since funds deposited in a bank or savings and loan association are backed by all the loans and investments of the bank or association and suitably protected by capital or reserves, failure of a single loan or investment need not result in loss to the individual saver. Further, specializing in the appraisal of loan and investment applications, financial institutions are able to develop a degree of expertise to which most individuals simply cannot aspire. Finally, the pooling of large numbers of small savings accounts affords economies of scale which reduce the borrowers' cost of acquiring funds while at the same time providing profit opportunities to the financial institution. The optimum allocation of capital afforded by the market and the advantages provided by financial intermediaries can be achieved only if financial institutions are